This copy is for your personal, non-commercial use only. To order presentation-ready copies for distribution to your colleagues, clients or customers, click the "Reprints" link at the bottom of any article.

July 28, 2011

Rob Arnott on RAFI’s Growth, and How to Address U.S. Debt

Fundamental indexing has been embraced worldwide, Arnott says, but the government and the U.S. people need to embrace some tough choices on spending

When Rob Arnott talks about the money that has been attracted to Research Affiliates’ various investment vehicles, he talks about billions of dollars. For example, since launching the RAFI—Research Affiliates Fundamental Indexes—approach to portfolio building five years ago, he said $54 billion in RAFI assets were now being managed or sub-advised by Research Affiliates and RAFI licensees.

He’s feeling good about the worldwide embrace of the practical notion of fundamentals-based indexing rather than cap-weighted indexing and thinks that growth will continue. But in an interview with AdvisorOne in New York on Wednesday, with talk of the U.S. debt ceiling filling the airwaves and corridors of the U.S. Capitol, the chairman of Research Affiliates and the driving force behind the fundamental indexing approach was talking about trillions of dollars. As in the level of federal debt.

“It’s an untenable situation,” said Arnott (left), referring not merely to the controversy over the debt ceiling but over the amount of government spending. The most serious issue right now, he said, is the United States’ AAA rating, and he says that merely raising the debt ceiling won’t mollify the ratings agencies, which already have the U.S. on watch for a possible downgrade. “We’ve got to keep our rating,” he says, recalling that “S&P was explicit” in its warning: “Get the spending reined in,” and at the $4 trillion level. None of the competing debt packages now being floated in Washington, he points out, is looking for $4 trillion in cuts.

(In testimony on Wednesday before a House Financial Services Committee panel, S&P President Deven Sharma sought to clarify what he suggested were misleading media reports about the $4 trillion figure, saying that number was only “within the threshold” of what the ratings agency thought was necessary for the U.S. to retain its AAA rating. Furthermore, Sharma said that “some of the plans” now being floated by the two parties in Washington could put the country’s debt outlook “in the range of the threshold of a triple-A rating.”)

While it remains unclear whether a downgrade will happen regardless of what transpires in Washington regarding the debt ceiling, Arnott suggested that one possible solution to appeasing the ratings agencies might come in the form of legislation—Ensuring the Full Faith and Credit of the U.S., or S. 63—proposed by Sen. Pat Toomey, R-Pa., originally in February and reintroduced Tuesday with 31 cosponsors in the Senate.

Under that bill, the government would be forced to make three of its debt obligations “sacrosanct”: paying debt service, funding Social Security and paying active-duty military, Arnott said. The government’s income would be sufficient to make those payments, he said, and could provide some breathing room to address the broader spending issues faced by the country.

“We’ve got to change course on our spending,” he said, and “accept the fact that our GDP is lower than it seems,” since he said the deficit already accounts for 11% of GDP. Since GDP actually tracks spending, Arnott said spending 11% on debt is tantamount to a family that believes it’s “economy” is in good shape because its

spending is financed by using credit cards. “It’s a dangerous morass,” Arnott warned, to think that increasing the cost of servicing debt can somehow be offset by much higher economic growth.

Not surprisingly for a company called “Research Affiliates,” whose primary business, he says, is “licensing our ideas,” Arnott said he had been doing a fair amount of research on “the three Ds—debt, deficits and demographics.” Arnott steered away from blaming one or the other political party for profligate spending—"It's bipartisan: the party of big government and the party of bigger government." While he wouldn't predict which of the two parties would blink first, he was confident that "the side that won't blink is S&P and Moody's."

How should portfolios be adjusted, then, in light of a possible downgrade and higher inflation? Bonds may be fine now, he said, but Arnott is less sanguine about fixed income over the longer term. Stocks, he warned, are little better, since they are at a level that suggests we’re at “an economic peak, not a trough.” Inflation-linked bonds such as TIPS would be more attractive, as would high-yield bonds, which he considers “stealth hedges.” Advisors have the tools investment-vehicle-wise, he argues, but the problem is that most advisors still have “90% of their portfolios in stocks and bonds,” which is not where you want to be, he counseled, in a reflationary environment.

He thinks it will be an "interesting decade ahead," but worries that the only way to get the country's fiscal house in order to fix Social Security and Mediacre is by raising the age of eligibility, cutting back on benefits, and instituting means testing. That will need to happen partly because of the increases in life expectancy, where someone retiring at age 65 may well get Social Security checks for many decades to come. He believes it's untenable to expect the children, grandchildren and great-grandchildren to pay for those long-living retirees.

Getting back to Research Affiliates’ impressive growth, Arnott acknowledged that there were vocal critics early on who have become “increasingly quiet,” as fundamental indexing “gains traction all over the world.” The traction is shown by $8 billion invested in the RAFI approach in Japan, $5 billion in Australia, $4 billion in Scandinavia and $6 billion in the rest of Europe (all numbers as of June 30, 2011). That traction and those assets attracted were helped, he said, by the early adopters of the RAFI approach—public funds, such as CalPERS, which has $6 billion in the approach, and retail—which turns on its head the normal adoption of newish investing strategies by institutions first.

Those constituencies, he said, we’re already highly invested in traditional cap-weighted index funds, “so they knew its drawbacks.” In addition, he said both financial advisors and RIAs “are increasingly interested” in the RAFI approach. Beyond the intellectual embrace of the fundamental indexing “intuitive” approach, the performance helps with adoption as well. Backtesting the strategy shows that a fundamental index approach adds about 2% performance over that of a cap-weighted portfolio of S&P 500 equities. Put another way, the outperformance is 2% to 4% in developed markets, Arnott reports, and over 4% in inefficient markets.